In 2005 I became a landlord. A good friend and I began investing in single family homes in the midwest. We purchased two HUD foreclosures in 2005, and since then we’ve added 3 more HUD foreclosures to our portfolio, and then sold two homes.
When we advertise one of our homes for rent, we always advertise the property as a rent-to-own home. Also called a lease option, we structure the agreement to allow the tenants to purchase the home within a specified period of time for a set price.
We’ve entered into several lease-to-own agreements with tenants, although we’ve only sold one of the homes to a tenant (more about that in a minute). This experience has taught me two things: (1) tenants make major mistakes when entering into a lease purchase agreement, and (2) some landlords take advantage of tenants who don’t understand how to approach a contract for a rent-to-own house.
For a time, when mortgage loans were easier to access, rent-to-own real estate fell by the wayside. Now, though, such arrangements are making a comeback. Renting to own can help potential home buyers get into a home before they save up a down payment. However, it’s easy to make a mistake in this arrangement, so we’ll talk here about how to negotiate a fair lease option and how to identify potential traps.
Here are the topics we will cover:
- Lease Options 101: A summary of a lease option, and points to consider when deciding whether a rent to own home is right for you.
- Treat a Lease Option Like a Purchase: Although there is no obligation to purchase a home during the term of the option, tenants should enter the deal as if they are buying a home.
- Key Lease Option Terms: A review of the following key terms–
- Rental Agreement
- Lease Option Fee (the 1% rule)
- Rent Credit (the 15% rule)
- Maintenance Obligations
- Purchase Price
- Financing a Rent-to-Own Purchase
- $8,000 Tax Credit
Lease Options 101
A lease option, lease purchase, or rent-to-own home involves two agreements: a rental agreement and an option to purchase the property.
The rental agreement in most respects is a standard landlord-tenant agreement to rent the property at an agreed-upon price for an agreed-upon term. The option gives the tenant the right to purchase the property within an agreed-upon time frame (typically one to three years) at an agreed-upon price.
There are several reasons why a lease option may be an attractive way to buy a home. First, lease options appeal to those who do not have enough money for a down payment. Through rent credits (see below), a tenant can accumulate cash that goes toward the down payment. In addition, during the rental period, the tenant can save money above and beyond the rent credit to put toward the house.
Second, for those who have a low credit score, they can work to improve their FICO score during the rental term. This can help them get better mortgage rates and terms once they’re eventually ready to buy.
And, finally, a rent to own home gives tenants an opportunity to live in the home and get to know neighbors before committing to the purchase.
Of course, you don’t have to rent a home with an option to buy to accomplish all of this. You can just rent a home in a neighborhood that interests you, save a down payment while you rent, and work to repair your credit score. But for those who do enter into a lease purchase, the above reasons are generally why.
Treat a Lease Purchase Like You’re Buying the Home
Before we look at the key terms, there is one very important consideration to keep in mind: you should treat a lease purchase property as if you are buying the home.
It amazes me how some people will put down a lease option fee and enter into a 3-year contract having spent 10 minutes in the home. Almost without fail, these people do not exercise the option to buy the home. Instead they move on to another lease option deal somewhere else.
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The goal of a lease purchase should be that you eventually buy the home. While intervening events may cause you not to exercise the option, you should treat the transaction as if you will. So, what does this mean?
First, you should inspect the home as you would with a purchase. Whether you hire a home inspector, have a friend or family member look at the home, or inspect the home yourself, you should look over the home as if you were going to sign a purchase agreement.
Second, look for a home you actually want to own. Often tenants enter into a lease purchase agreement because the home happens to be available, not because it’s a home they truly want to own.
And finally, negotiate all the terms of the deal as if it were a purchase. And with that, let’s look at the key terms of a lease option.
Key Lease Option Terms
Here are a few key terms you should be familiar with before ever considering a rent-to-own situation.
A lease option is, first and foremost, a rental agreement. The key terms in any rental agreement are the rent and the term. In these deals, however, there are two key points to remember.
First, the rent should be whatever reasonable market rent the home justifies. The rent should not be higher because of the lease option component of the deal. Remember, you’ll be paying an option fee, which covers the value of your right to purchase the home. The rent is the rent. I’ve heard horror stories of tenants agreeing to outrageous rents because the landlord convinced them it was justified in light of the lease option.
Second, the term of the option should give you enough time to save up a down payment and repair your credit. If you know this will take two or three years, a one-year option is a waste of time and money.
If you are not sure how long it will take you to qualify for a loan, talk to a mortgage broker before entering the deal. They should be able to give you some idea of how long it will take to get your finances in order to qualify for a home mortgage. Generally, terms of two to three years are common for rent-to-own single family homes… at least they are where we invest.
Lease Option Fee (the 1% rule)
The lease option fee is the cost of the option to purchase the home. The option lasts for the length of the rental term, typically. In other words, if the rental term is three years, the option gives you the right, but not the obligation, to purchase the home anytime during those three years. When you negotiate the option fee, keep three key factors in mind:
- The amount of the option fee (about 1% of purchase price)
- Whether the fee is refundable (generally, no)
- Whether the fee applies to the purchase of the home (generally, yes)
First, of course, is the amount of the fee. As a rule of thumb, 1% of the purchase price of the home is reasonable. The homes we rent range in value from about $130,000 to $175,000. The option fees we charge generally range between $1,450 and $1,950, which is slightly higher than 1%.
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However, we do not require tenants to put down a security deposit on a lease purchase deal. I’ve seen landlords ask for and get option fees as high as 5%. I suppose if they can get it, why not ask. But as a tenant, 5% is just too high in most cases. If a property owner is asking for 5%, negotiate or keep looking.
Second, recognize that option fees are non-refundable. If you don’t buy the home, the landlord still keeps the fee. In this way, a lease option for a home is similar to an option contract on a stock. The cost of the option is not refundable even if you choose not to exercise the option.
As a result, you should think carefully through the transaction before entering the agreement. Decide whether you really want to purchase the home, and whether you’ll have the financial means to do so, during the term of the option.
Finally, make sure that the fee will go toward your down payment if you exercise the option to buy. While this is typical in my experience, you may find some landlords who seek to treat some or all of the option fee differently.
In most lease purchase arrangements, the tenant receives a credit that will go toward the purchase price if they buy the property. This money goes to the homeowner, and is generally not refundable. So it doesn’t go into an escrow account, and it doesn’t go back into your pocket if you decide not to buy the home. But it does reduce the home’s purchase price if you decide to purchase the home.
While there is no universally agreed-upon amount, for residential real estate, 10% to 15% of the monthly rent seems to be a good rule of thumb. For a home costing $1,295 a month, for example, we offer a monthly rent credit of about $150. The rent credit is an important part of the deal for tenants for at least two reasons.
First, it of course reduces the cost of the home when you exercise the option to buy it. And second, it can help you build up a down payment on the home. The key is to make sure that the deal includes a fair rent credit.
When you look at the terms of the agreement, be sure to look at more than just the amount. For instance, we make the rent credit contingent on timely payments. If the rent is late one month, our tenant loses the rent credit for that month. This is a common arrangement, and one you’ll want to have on your radar as a tenant.
Recently, we’ve started shifting the maintenance obligations over to the tenant. This practice is not uncommon, particularly with land contracts or rent-to-own arrangements. From a tenant’s perspective, though, taking on the responsibility of maintaining the property may seem like an unwanted financial risk. Well, to some extent it is.
The contract should spell out exactly how maintenance time and costs are divided. For instance, the buyer may be responsible for basic lawn maintenance and exterior/interior maintenance, but only responsible for up to a certain dollar amount per year in maintenance charges.
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You can also divide basic maintenance from capital improvements, such as replacing the roof. Again, not all contracts will specify these issues, but adding them into yours could be a good idea.
If you do find a landlord who wants you to assume the maintenance obligations and you’re willing to accept this responsibility, here’s a tip: instead of taking on this responsibility on day one, consider delaying the transfer for six months. This gives you a chance to identify any latent issues with the home and to get them repaired on the landlord’s dime. In effect, this gives you a six-month warranty on the home.
Tackling the maintenance on the property on your own after this period may seem onerous. But it will also help you see if the property is one you can handle as a homeowner.
Tenants make two big mistakes when negotiating the purchase price. First, they don’t negotiate for a lower price. Second, they enter into option-to-buy deals where the price is not fixed.
Since we began offering our homes on a lease purchase, not a single tenant has even tried to negotiate the purchase price. This is a big mistake. The purchase price is always negotiable on a lease purchase deal, just as if you were buying the home outright.
It’s easy to research home values on the Internet. Begin with online home value websites to get a rough guide. Then, look at comparable homes that have sold in the last six months. Armed with this information, negotiate a fair price.
Whatever price you agree on, it should be fixed during the term of the option. Avoid deals where the purchase price will be “agreed upon” later or based on some future appraisal. The option fee is paid in exchange for the right to purchase the home for a set price within an agreed upon period of time. If a landlord won’t agree to a fair, fixed price, look for another property.
Financing a Rent-to-Own Purchase
It may seem odd to talk about financing, since you won’t need a mortgage unless and until you decide to buy. But my recommendation is that you talk to a mortgage broker BEFORE entering into a lease option. A good mortgage broker will give you an honest assessment of your chances of being approved for a loan during the term of the option. While a broker can’t offer you any guarantees, they can arm you with important information that will help you make the best decisions for you and your family.
A lease purchase can be a reasonable way to purchase a home. Particularly if you’ve recently been through a bankruptcy, have bad credit, or lack enough cash for a down payment. In those cases, a rent-to-own home may be a good option.
If you’ve ever purchased a home this way, or have additional tips for others, please share your experience in the comments below.